Lecture 5

• Bank balance sheets include sources and uses of funds.

Sources of Funds

• Liabilities:
  • Core deposits.
  • Managed liabilities (purchased funds): more volatile, rate-sensitive, gathered in national or international bond/money markets.
• Equity:
  • Equity capital (book value): Net Worth = Assets – Liabilities
  • Regulatory capital: Leverage ratios/Equity ratio = E/A; typically low

Use of Funds

• Interest-earning assets: loans and leases, investment securities
• Fee-generating assets: management fees, advisory fees
• Non-earning assets: buildings and real assets.
• Largest assets are typically net interest and net commission income.
• Largest liabilities are typically personnel costs and IT expenses.
• Fixed costs allow for companies to exploit economies of scale by increasing net assets and the number of investors; however, companies can experience diseconomies of scale.
• Net commission income is relatively stable and only increases as the number of investors increases.
• For Aktia equity is about 10% of total assets and liabilities.
• Bank performance is assessed via ratio analysis of profitability (cost-to-income, ROA, ROE) and solvency (core tier 1 capital ratio)
• Other meaningful comparisons: time-series analysis (comparing a bank's performance over time), peer-group or cross-sectional analysis (comparing banks' performance across similar banks in the same industry or region), using control variables (ensuring fair comparisons considering factors like bank size, location, or organizational structure).

Cost-to-Income Ratio

• A company's costs in relation to its income, calculated as operating costs (administrative and fixed costs, excluding bad debt written off) divided by operating income.
• Used by investors to gauge operational efficiency.
• Lower ratios signify higher profitability.
• Cost-to-income ratios of firms vary a lot, but typically around 40-60%.
• Aktia has been struggling to achieve its target cost-to-income ratio and has closed off some of its branches to increase it.
• Greater customer preferences for digital services mean this is more cost-effective for banks.
• High switching costs can hinder traditional bank growth.
• The move towards asset management is making it easier for some banks to increase profits
• Regulatory capital is a measure of a bank's common equity capital as a percentage of risk-weighted assets.
• Common Equity Tier 1 capital (CET1) represents a bank's shareholder equity and retained earnings.
• Tier 2 capital is a bank's revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and undisclosed reserves.
• Capital adequacy ratio can be calculated with the formula Risk Assets Ration (RaR) = (Tier 1 Capital + Tier 2 Capital)/Risk-weighted Assets.
• Aktia's capital adequacy ratio has improved with an additional buffer of around 3%.

Basel Committee on Bank Supervision

• A global standard for financial stability which implements regulations as accords.
• Basel I is focused on RaR with a tier 1 capital requirement of 4% and a tier 1+2 requirement of 8% of risk-weighted assets for all banks.
• Asset value is adjusted by risk class; examples: gold and cash have 0%, mortgages are 50%, and corporate loans are 100%.
• Riskier assets require institutions to hold more capital.
• Institutions can increase their capital ratio by:
  • Increasing capital through issuing new shares or retaining profits by not paying dividends.
  • Reducing risk-weighted assets, cutting back lending, selling loan portfolios, making less risky loans and investments.
• Basel II introduced a more complex weighting scheme with loans evaluated by credit rating.
  • Corporate debt would be rated on the credit rating of the company it is issued to.
• Basel III is being gradually adopted but is an evolving framework with varying paces by country.

Internal Rating-Based Approach (IRBA)

• Big banks can use their own risk models with supervisor approval.
  • These models require demonstration of sophisticated risk management.
• IRB models estimate the probability of default for each rating class and loss.
• Aktia was given permission to use the IRB model, with the IRB approach reducing the average risk weight of retail collateral and improving Aktia's CET1 ratio.
• Large improvements in banks' CET1 ratios have led to concerns about the use of the IRB models to reduce risk and lower equity required.
• Leverage ratio = tier 1 capital/average total consolidated assets.
  • Basel III introduced a minimum of 3% which is a non-risk based, backstop measure.
• There is no market assessment and large information asymmetries about many bank assets and loans.
• Stress tests and Asset Quality Review (AQR) aims to reduce and improve transparency.
• Basel IV decided banks have too much freedom in risk assessment aiming to give floors on risk levels.
• Banks oppose new rules to avoid increasing their equity and delaying the adaption.
• European banks argue on the level playing field with US banks, for if Basel III is postponed in US, so will Europe.